Young Investors: Understanding Diversification and Why It Matters

If you decided to make 2017 the year you start investing, congratulations. You have taken a big step towards achieving financial independence.
If you’re new to investing, there are a lot of buzzwords financial advisors use in the world of investing. One highly familiar word is diversification. For investors who are just starting out, you may have heard this term and you may be wondering what diversification is and why it matters. Financial coach Mark Matson reviews the meaning of diversification and why it’s important.

Defining diversification
Many are familiar with the common saying, “don’t put all your eggs in one basket.” It’s a phrase frequently used by financial experts. Diversification is commonly a vital component to reaching your long-term financial goals. The goal of diversification is to reduce risk, which is done by allocating your investments among various asset classes. By spreading around your investments, they will react differently to the same events, generally maximizing your return.

Why diversification matters


As previously mentioned, diversification is simply about spreading your portfolio across various asset classes. Diversification is not necessarily to boost performance and it won’t guarantee a profit, but it does substantially help balance risk and reward in your investment portfolio. It may provide the potential to improve returns for your level of risk.

  • Look for different asset classes

    In order to create a diversified portfolio, you should look for different asset classes. Different assets, such as stocks, bonds, cash and others, typically don’t react the same way to the same events. Look for assets whose returns haven’t moved in the same direction and the same degree over the years. In doing so, even if a part of your portfolio declines, the rest of your portfolio may be growing.

 

  • Different levels of risk tolerance

    One key to successful investing is choosing your risk tolerance based on your financial goals and time horizon. Young investors can seek bigger returns by taking bigger risks. This is because if they lose money, they have time to earn back their losses. Invest too conservatively at a young age and the growth rate of your investments may not outpace inflation. Conversely, if you invest too aggressively when older, you are at a higher risk of losing your assets and will be less able to recover potential losses. Therefore, investors with lower risk tolerances should typically shift their portfolios toward a lower risk/reward investments.